Advantages and Disadvantages of Incoterms

Issues and Concerns in Global Sourcing Decisions

Introduction

Global trade offers businesses the opportunity to tap into new markets, expand customer bases, and acquire unique resources unavailable domestically. However, this venture into the international market comes with complexities such as varied legal regulations, logistical hurdles, and potential miscommunication due to language barriers. A significant instrument in easing these challenges is the utilization of Incoterms, which are standardized trade terms published by the International Chamber of Commerce (ICC). The ICC's Incoterms act as a universal language for traders, offering clear, concise, and comprehensive definitions and regulations to bridge the potential misunderstandings in international contracts. This paper examines the value that Incoterms bring to international trade agreements, the advantages and disadvantages of using specific Incoterms, and the essential knowledge companies need to have when using Incoterms in their agreements.

Use of Incoterms in International Trade

Incoterms, short for International Commercial Terms, are a set of rules published by the ICC that are intended to make international trade easier and more predictable. They are used in contracts for the sale of goods worldwide and provide rules and guidance to importers, exporters, lawyers, transporters, and insurers, among others.

The main value that Incoterms bring to an agreement is clarity. For one thing, the establish standardized rules and definitions for the most commonly used terms in international trade. In so doing, they help to reduce or eliminate altogether uncertainties arising from different interpretations of these terms in different countries. This clarity helps avoid disputes and misunderstandings between parties involved in international trade.

Each Incoterm specifies the obligations, costs, and risks involved in the delivery of goods from the seller to the buyer. These can include tasks such as who is responsible for loading and unloading the goods, who pays for transportation and insurance, and at what point the risk of loss or damage to the goods shifts from the seller to the buyer.

For instance, in the Ex Works (EXW) term, the seller is only obliged to make the goods available for pickup at their premises or another named place (De Sousa, 2021). The buyer then assumes all responsibilities for transporting the goods to the final destination. In contrast, under the Delivered Duty Paid (DDP) term, the seller assumes all obligations until the goods are delivered to the buyer's location, cleared for import (Piltz, 2020).

Incoterms also make clear who is responsible for the various costs associated with shipping, such as packing, documentation, export and import duties, loading charges, and freight. For example, under the Free on Board (FOB) term, the seller must cover all costs until the goods are loaded on a vessel at the named port of shipment. From there, the buyer is responsible for all subsequent costs (Douar, 2022).

Incoterms also define the point at which the risk of loss or damage to the goods transfers from the seller to the buyer. In the FOB term, risk transfers when the goods have been loaded onto the ship. Under the Carriage Paid To (CPT) term, risk transfers when the goods have been handed over to the first carrier, even though the seller still has to pay freight charges to the named destination.

Certain Incoterms, such as Cost, Insurance, and Freight (CIF) or Carriage and Insurance Paid To (CIP), even specify that the seller is responsible for procuring insurance cover for the goods during transit.

Advantages/Disadvantages

The advantages or disadvantages of using a specific Incoterm depend largely on the specific circumstances of the transaction.

EXW (Ex Works)

The advantages for the seller using the EXW term are significant. There is a minimization of risk as the seller's responsibility ends as soon as the goods are made available at their premises. They have no obligation to load the goods on any collecting vehicle or clear them for export, hence reducing their exposure to risk. Moreover, under EXW, the seller is not required to bear any costs associated with transporting the goods beyond their premises, thereby potentially lowering their financial obligations.

However, the EXW term can be disadvantageous for the buyer. The buyer takes over all costs and risks once the goods are made available at the seller's premises. They are responsible for loading, transporting, and insuring the goods from this point forward, as well as for handling all export and import procedures. If the buyer is not well-versed with the export regulations of the seller's country, they might face legal and logistical challenges that could delay the shipping process or increase the cost.

DDP (Delivered Duty Paid)

Conversely, the DDP term brings a number of advantages for the buyer. The seller assumes responsibility for all costs and risks associated with delivering the goods to the buyer's location, including export and import duties. This significantly reduces the buyer's logistical burden. In addition, under DDP, the buyer knows upfront the total cost of the goods, including delivery and import duties, which aids in financial planning and budgeting (Piltz, 2020).

The DDP term can, however, be disadvantageous for the seller. The seller assumes all risks and costs associated with transporting the goods to the buyer's location, including import duties, taxes, and other charges. This places a high financial and logistical burden on the seller. Moreover, if the seller is not familiar with the import regulations of the buyer's country, they might face challenges that could lead to delays, unexpected costs, or legal complications (Piltz, 2020).

What Companies Need to Know

Companies need to understand several key things when using Incoterms. Firstly, they need to know that Incoterms do not cover everything. For instance, they do not determine ownership or title transfer of goods. Such details need to be specified separately in the sales contract.

Secondly, they need to be aware of the latest version of Incoterms, which is currently the 2020 version. The ICC updates the Incoterms rules every 10 years to reflect changes in international trade practices. Each new version supersedes the previous one, so it is important to specify in the contract which version of the Incoterms is being used.